Sunday, September 22, 2019

Capital Cycles Changing? - Weekly Blog # 595

Mike Lipper’s Monday Morning Musings

Capital Cycles Changing?

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

The critical lesson of living we must deal with is that all of life is cyclical. As investing is an abstraction of living, investors must deal with cycles. Our cycles occur along the spectrum of capital, going from capital appreciation to capital preservation or from highlighting goals of success to those of survival. A somewhat parallel spectrum is arrayed between “growth” and “value”, as we choose to define them. It is often useful to determine where we are in the spectrum by relating current values to those at the extremes. The activists believe they can consciously time their movement from one extreme to another, while  historians are generally more comfortable mid-range. This dichotomy was evident during the past two weeks.

Where Are We Going?
Far too many words have been written recently giving directional advice without understanding where we are in the investment and market cycles. The distinction between the two related cycles is that investment cycles begin with intelligent and prudent transactions, while market cycles record sudden shift in prices. Somewhat suddenly two weeks ago, “value” stocks and funds began performing better than the prior leaders marching under the banner of “growth”.  This past week the momentum in favor of “value” was absent or subdued. This is not surprising as growth has been a consistent winner for ten years and in the first four days of the week transactional volume was low. “It takes a long time to turn a battleship” was one of the lessons taught us in the Naval Reserve Officers’ Training Corps (NROTC).

Is There a Change Happening?
When one is in a turning phase it is almost impossible to be certain of the future direction. Is it a ninety degree, one hundred and eighty degree or three-hundred-and-sixty-degree turn? There are at least four bits of evidence that something out of the ordinary is happening.
  1. Falling prices have seen more volume than those rising in this week’s transactions. (More dollars are leaving than coming into the market.) 
  2. On Friday there was a surge in the transactions of asset management stocks, e.g. T. Rowe Price (*) traded almost 3 times its average volume of the prior four days.
  3. High-quality debt yields declined more than intermediate-quality debt based on the latest week’s yields. (Bond prices move inversely to yields, so the desire to own high-quality paper with reduced income is a sign of concern for both bond and stock prices.)
  4. WeWork’s proposed IPO price, after dropping by two-thirds, was withdrawn. (In the weekend edition of the Wall Street Journal, my friend Jason Zweig intelligently questions the myth that private investing produces better results than publicly traded investments. The significance of this belief is that many tax-exempt institutions and wealthy individuals have put substantial amounts of their capital into private securities, believing that their lack of liquidity and disclosure are exchanged for better performance, often caused by their  IPOs. I am familiar with several cases where this didn’t work out.)
(*) T. Rowe Price, the premium publicly traded asset manager, is in both our Financial Services Fund and personal accounts. They are predominantly an investor in publicly traded securities. However, in some of their funds they have been an early investor in private companies. The maximum share that I have seen in their equity portfolios is 7% in privately held securities. Many of these have been good investments and losses have been small over the many years they have been investing in privates.

What is “Growth” and “Value”
Investors use labels as an abstraction to convey a series of integrated, complex concepts. The essence of “growth”, “growth stock” and “growth stock fund” is the rising of stock prices above those found in the general stock market on a secular basis over multiple market price cycles. This definition ignores both short-term and economic cycle price swings around an upwardly sloping trend line. Another way of expressing this concept is that growth companies have profitable products and services, which are met with increasing acceptance by both customers and investors. There is a problem with that definition in that the label is unlikely to be permanent for all time, due to its dependence on the perceived ranking versus their competitors. However, some companies have appropriately maintained the label for a long time. The trick for investors is to identify when that the label is slipping. Renewed, skeptical analysis is needed.

There are many ways to define “value”, because value is in the eye of the beholder. The original investors were the primary investors betting on the success of the venture. The follow-on investors were cashing out the originals and had to question the offered price relative to other alternatives. The second set of investors thought of value in terms of a discount relative to present prices. The history of Security Analysis is that it was developed as an offshoot to accounting. The original course by Ben Graham and Dave Dodd started with the analysis of the assets behind bonds, which were selling below both their maturity price and the statement value of the assets. We were taught to schedule the cash conversion schedule of the assets. Greater weight was readily given to  assets converted to cash, like finished inventory vs. plant and equipment etc. This led to a group of buyers who were labeled “net-net buyers”. Ben Graham, Warren Buffett and the late, great Irving Kahn were some of these.

Because of a much higher level of public disclosure and computer searchable financial statements, there are relatively few net-net opportunities in most developed countries markets. In its place some have used the discount from book value or net asset value for fund vehicles as a substitute. For the most part this has not worked particularly well because balance sheets record historic asset acquisition prices adjusted for annual depreciation and impairment costs. Book values are rarely written up according to accounting and regulatory rules. Recent attempts to capture the discount on closed end funds has not been successful. First, it takes time, effort, and often money to displace the present management. Second, there is likely a difference in price form the last sale at the end of a day and the actual price received in liquidation.

So Where Are the Value Opportunities Today?
There are quite a few that are the equivalent of Sherlock Holmes in the mystery of the dog that didn’t bark. The focus should be on what is not on the balance sheets of both assets and liabilities. One example is real estate for an operating company. Royce & Associates (**) has a fund that invested in Steinway, the concert piano manufacturer, which was not growing. However, uncaptured on its balance sheet was the air rights above its low-level 57th street show room and their large facility in a rapidly changing section of Queens. This proved to be very profitable when the real estate was liquidated. Much like a chain of cigar stores on many prominent corners in Manhattan, which lost money as tastes shifted, but had very long-term leases on their stores.

Today, in many companies the most valuable asset is the lists of customers and what they purchase. Two examples are stocks that I own personally, neither of which I expect to liquidate even though they have understated book values. Apple’s one billion customers names and spending habits proved that an asset could predict future sales, much like when car owners traded in their vehicles every one to three years. Another company that is assembling a combined customer information databank is CVS, which is combining its pharmacy and health insurance customers. Not only are there repeat business opportunities, but the potential to identify new demand as new drugs and services are developed. I suspect Amazon could create the same type of value, which is essentially a derivative of DE Shaw’s ability to predict market prices.

Is There Another Approach?
Believing in cyclicality, I often look at the worst performing investment objectives compared to the best. (This works for a group of funds, but not necessarily for individual funds where differences in skill levels are apparent.) In the last five years the average growth fund of all sizes, both domestic and international, averaged a gain of +7.57% compared to value funds which gained +3.50%, or effectively half. Thus, one can see my initial attraction to the possible shift in favor of value. Even with this instinct when investing new money we are more weighted toward growth for long-term accounts, but we are slowly increasing our exposure to value. The reason for the slowness is that we could still have another strong bull market led by growth. We are very close to record price levels, with the Dow Jones Industrial Average behind -1.55%, S&P 500 -1.12% and NASDAQ -2.55% from their record highs. We are paying attention to the NASDAQ as it is the most speculative of the indicators and is the one that has recently shown significant selling volume.

(**) My son who is the senior investment strategist for Royce Associates and was not involved in that decision.

Need Help?
If you would like to discuss any of these thoughts or how to structure your portfolio, please contact me.

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Sunday, September 15, 2019

Concentrate or Diversify, 2 Questions with 3 Answers - Weekly Blog # 594

Mike Lipper’s Monday Morning Musings

Concentrate or Diversify, 2 Questions with 3 Answers

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

I have been asked to respond to two intellectual investment questions that parallel real word actions. The first question comes from a long-term subscriber of these blogs. The second comes from my preparatory work for a potential investment management client.
  1. European Portfolio Manager response to Sub-Zero Interest Rates?
  2. Appropriate Structure for a Long-Term Charitable Account?
In my mind both questions revolve around the same risk management question. Is it better to concentrate one’s assets and energy or spread the risk by diversifying? Too often investment people view their problems as special and quite separate from the real-world problems of others. We do this at the risk of not seeing the universality of problems.

Perpetuation of the family/species is at the core of human and animal creation. Due to potential violence, insufficient food, and medical risks, some produce multiple offspring with the hope that some will survive. Others choose to produce a limited number of descendants and protect them carefully. This is the very same quandary that investors face, particularly those with responsibly for others.

One approach to a decision process with two alternatives is to create a barbell type solution by combining the two extremes of diversification and concentration. To be prudent we should not use this barbell decision model. The third element to consider is the presence of other factors, which often determines the appropriate decision.

Reactions to Negative Interest Rates
On the surface, paying a financial institution for the privilege of letting them hold your money, which they then lend out without sharing the proceeds with you, appears to violate Newton’s laws of physics. It suggests a collapsing universe rather than an expanding one, raising the question of why an investor would contribute to such a scam?

Jim Grant, one of the best columnists on fixed income, called for the end of the 38-year bond bull market in this week’s Barron’s. In his column he quoted from a 1981 article by Parker Hall, a deceased but old friend who heralded the beginnings of the bond bull market. Today’s question is somewhat more complex than just betting on a cyclical turnaround in bond prices. It has been made more complicated by the policy dictates of various governments for political purposes. Although interest rates are expressed in their local currency, e.g. euros, they are compared to rates in other currencies and are exposed to different inflation rates. Governments, officially or unofficially, direct their central banks to induce low interest rates to create and preserve jobs, often through problematic loans which create additional market distortions.

Most large fixed income portfolios are managed through or for the political establishment, making it difficult for many managers in Europe to meaningfully exit from negative interest rate paper. However, I am seeing some increased diversification into both high-quality corporate bonds and very long-term government bonds, including century bonds. The latter is interesting in that they’re betting they can, over the long-term of possibly 100 years, reinvest the low yielding coupons at higher expected interest rates. (It is worth noting that the biggest return in long-term bond investing is through the reinvestment of payments at current rates).

If European fixed income managers can get out of the euro they generally will, often by buying US paper. Most cannot and are therefore effectively corralled into the euro and forced to extend their maturities. However, there is a limit as to how much they can lengthen their maturity structure, as many portfolios are designed to pay pension benefits. In most European countries the retirement ages are lower than in the US, thereby limiting maturity elongations.

Portfolio Structure for a Charitable Investment Account
The payout needs for any account requires current cash to make payments. There are two main ways to achieve this. The traditional way is to let the gross income earned on the entire account make the required payments, but due to market price fluctuations the available cash will fluctuate. To the extent that current income is insufficient, proceeds from sales can supplement the cash generated from dividend and interest payments.

We are advocates of another approach which divides expected payment responsibilities into specific timespan portfolio sub-accounts. The most current timespan portfolio should generate the funding necessary to make required payments. This portfolio could be structured in a way where cash or short-term investments satisfy the payment obligations before being replaced with the next timespan tranche. The advantage of this approach is that it makes certain that current bills are paid, regardless of market volatility. It also allows the rest of the portfolio to be invested for longer term horizons.

Charities, even private ones, are fiduciary accounts that are distinct from personal accounts. No one must know how well or poorly one’s personal account performs. Most fiduciary accounts make reports as to the success of their investment program from time to time and the frequency of this reporting can influence how a portfolio is managed. Financial markets are by their nature volatile. Over very long periods a fully invested portfolio of reasonably selected securities or funds should produce a higher return than a portfolio that has frequent changes.

To some degree, in dealing with fiduciaries it is more difficult to manage their expectations than manage the performance of the funds and/or securities. Using a rough rule of thumb, the potential peak to bottom declines are as follows:

     A 10% decline - Three times in a ten-year period
     A 25% decline - Some time over a ten-year period
     A 50% decline - Once in a generation of approximately 25 years

Many investors do not achieve the general returns available in the market because of timing their moves in and out of the market.

Diversification reduces specific risks of individual securities. However, it also reduces the opportunity for doing much better or worse than the market average. Over an extended time period, wise concentration in a small number of choices produces the highest returns, but the results can be volatile.

Pulling these thoughts together the following structure may be appropriate for a charitable account, assuming a ten-year horizon:

     10% in Money Market funds and short-term US Treasuries
     40% in growth funds of various sizes, most in mid/small-cap funds
     30% in international funds, with 2/3rds in Asia
     20% in value funds

The selection of individual funds will be guided by risk tolerance, size of the account, operating procedures, and special factors. The higher the risk tolerance the greater the commitment to a concentrated portfolio of funds.

If you need help in constructing or reviewing your portfolio, please contact me.

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Sunday, September 8, 2019

Short and Long-Term Opportunities with Risks - Weekly Blog # 593

Mike Lipper’s Monday Morning Musings

Short and Long-Term Opportunities with Risks

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

Mid-course corrections and structural changes represent both opportunities and risks. Opportunities and risks are rarely separate from each other. My process for dealing with each, travel along similar routes:
  • Early, but not too early recognition. (Statistically there is not much difference from a discovery that’s too early and being labeled wrong)
  • Identify the magnitude (Large to life-changing vs. time and reputation risk, which can’t be recovered)
  • A research plan to narrow the number of opportunities and risks. (We can’t deal with too many variables)
  • An initial plan of action (Casualty lists are full of those who were too motionless)
  • Frequent adjustments to the plan. (Frequent but not too frequent, there is time needed for others to react reasonably)
  • Listen to both extreme historians and futurists. (They are often the same)
  • Create short-term achievable goals. (A passing grade is better than 100%, from which you can’t learn)
  • Cut the losses when other opportunities appear with lower risks. (Most great discoveries/inventions are bi-products of research efforts seeking other solutions)
Subscribers could use the above principles in reviewing what comes next.

Mid-course Correction?
US stock prices since late July have violently fluctuated in a trading range, as measured by the three major stock indices.  At the lowest point they were about half-way to a normal 10% correction. As of Friday, they were within a good trading week to their former peaks, achieved in July: Dow Jones Industrial Average -2.05%, S&P 500 -1.56%, and NASDAQ Composite -2.73%. This blog is prepared for long-term investors and I am therefore not going to focus on the momentum driven traders that dominate the market these days, especially when long-term investors are nervously enjoying gains generated over the last ten years.

While the market and economies are not driven by the calendar, investors and the media tend to focus on annual returns. I am concerned that while most stock and equity fund investors have not yet reached a gain of 20% year to date, a large number have. I am wondering whether the market indices will go through their old highs with some enthusiasm, or whether they will be stuck in a price range with high volume, encouraging some equity investors to take some chips off the table and wait for the clarity they expect in November of 2020.

This is not a political judgement; one expects to see some damage from low interest rates and falling currencies. These investors should remain equity investors in stocks and funds, perhaps with some rearrangement of their choices. However, under no circumstances should they have less than 50% invested in the stock market, re-entry costs and tensions are high for taxable investors.

Fundamental Changes for Long-Term Investors
There are two very important changes that are likely to impact successful investing in the future:
  • The appropriate nature of invested capital
  • Fewer workers and more mouths to feed 
Adapting to the Changing Nature of Capital and Investing
The earliest identified capital included physical things like land, jewels, and weapons, etc. One could see them, and an experienced person could evaluate their worth. Thus, the earliest recorded loans were mortgages or collateral. The wonders of double entry accounting recognized an assets value as the residual of its depreciated cost. Thus, the earliest investors concentrated on collections of assets, which led to analyzing balance sheets. This may well be appropriate in a world where the physical reality of assets is well understood, but that is not the reality today and increasingly it will be less so in years to come. Over one hundred years ago JP Morgan, himself that as a banker, made loans based on a person’s character, not their collateral. Nevertheless, today we still group companies in terms of their manufactured products, while our politicians focus on manufacturing jobs and their related products.

The service sector has been more productive in the production of wealth than the manufacturing sector for some time. Matter of fact, most successful manufacturers are also good at providing service and arranging financing for their customers and themselves. I would certainly include salespeople as being service workers, both within and outside every business today. We have entered a low interest era which appears to limit profitability.  Some wonderful old companies having more physical constraints are producing well respected brands but have suffered sales and other problems leading to significant layoffs. Some of these workers will retire or leave the industry, others will go to competitors in much smaller and more specialized elements of their industry. I see this occurring in older tech, pharmaceutical, and financial companies.

For many years CEO’s have thanked their most important asset, their employees, in their annual report letter. Since recruitment has become an important responsibility of senior management, critical employees are identified as “talent”. To those who think about these things it creates a dilemma. Do we as customers continue to rely on highly respected brands, or do we seek out products and services from which organizations are supposedly attracting the best talent? We face the same question as investors, especially the choice of colleges for those with children and/or grandchildren.

As an investment manager using financial services stocks and diversified mutual funds from around the world, I deal with this problem daily. A good long-term investment in these arenas needs good portfolio managers, salespeople, and good administrators. It also needs top management who wishes to have these people and can manage them, which is not easy. The problem today is dealing with the layoffs. The Financial Times noted that trading and advisory revenues dropped 11% in the first half of 2019 for the 12 largest investment banks in the US and Europe. We have seen most of these businesses shedding people, many of which were servicing and supporting the investment and wealth management efforts, both for their own companies and external clients. The people I know are looking because they have been laid off, or because they see significant elements of decay in their shops and want a better home to practice their art. With these people I could produce the best investment team in the world, but it unfortunately won’t happen because these people aren’t capable of working well together.

I am currently focusing on a small number of turnarounds which have similar characteristics. In the past they’ve had some good performing mutual funds, good sales teams, and good administration that was largely done in house. What makes these potential turnarounds interesting is that they have retired their old management. They now have new management that is busy trying to hire the right people to run critical parts of their organization. While the companies I am looking at are publicly traded, the new top management is long-term focused and not looking to the next earnings report. Not all of them will succeed, perhaps none will. But if they don’t succeed in a reasonable time, they’ll not be able to attract the needed talent and will be forced to merge to save a limited number of jobs. Often the acquirers are not much better than the acquired, just richer. Some will be successfully turned around if they can benefit from what I see and show next.

Retirement is Necessary for Our Success in the Future
Barron’s had a cover story this week “How to Fix the Global Retirement Crisis”. It points out that in 2050 there will be more people over 65 than under in the US. Japan has already reached having 59% over 65, in the US we are at 38%.  I would suggest we need to find ways to keep able and willing people working. At the same time, we need to find humane ways to free up some of their jobs for younger workers who can do more with those jobs. Most of the time seniors are healthy and want to be active mentally and physically, if they have the financial resources to do so.

In some respects, the mutual fund industry is one of the luckiest of all industries. A substantial portion of its growth has come from external forces, usually the government looking after senior voters. In the US the federal government passed legislation which created individual retirement accounts, salary savings accounts (401k, 403b, and 457 plans), tax exempt mutual funds, and money market funds. Without these the fund industry would have been much smaller. Things are similar in other countries, but they’ve used different measures to aid their own fund industry. The leader is Australia, which mandates that 9.5% be contributed to superannuation funds, a number that is expected to rise to 12% in the future. If one combines that with a history of no recession for 28 years, future retirees can look to a sustainable retirement. Considering seniors vote more often than other age groups, one would think that the US government might address their needs.  This could even cause the interest rate of savings to rise to a level that would reduce future unemployment through sounder loans.

Investment Suggestions
  1. Use the present market to clean up your portfolio of losers that are unlikely to soon return your cost.     
  2. Focus new investments on companies attracting good talent.
  3. Restrict brand buying to your consumer needs, not investments.
  4. Be prepared for opportunities and problems.    

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A. Michael Lipper, CFA

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Monday, September 2, 2019

Excess Capital + Less Equity Opportunities + Political Fears + Psychographics = Rate Inversion? - Weekly Blog # 592

Mike Lipper’s Monday Morning Musings

Excess Capital + Less Equity Opportunities + Political Fears + Psychographics = Interest Rate Inversion?

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

The extra day in the Labor Day weekend allows us time to think about the above thought equation. The factors listed are more important than the reaction to short-term yields being higher than long-term yields. There will ultimately be the inevitable recession of unknown date. Since the beginning of recorded financial history there have been periodic recessions to wipe out excessive risk taking. Currently, I see a limited amount of excessive risk assumption, mostly in unsound credit extensions and trading leverage. While these are important, they are probably insufficient to generate a broad economic recession. Nevertheless, the factors listed are significant enough to cause a disruption of some magnitude and length.

Excess Capital
The investment markets, particularly in the US, have produced returns at a higher rate than the growth of the underlying economy. One of the lessons from both human and animal history is that too much success leads to failure through over-supply. Sir Isaac Newton viewed the laws of physics as the tools of the Watchmaker in the sky. Thus, the laws of gravity were immutable and it is also probably true regarding the returns on invested capital. Compared to the US return on capital at its last peak in 2006 the current reading is lower, even though the size of the capital base is much larger. This suggests the law of large numbers is at work, making it difficult to sustain high rates when the base rises. Publicly-traded companies recognize this, and don’t want to have an extra-large pile of cash on hand, making them the target of a raid. Their three-fold approach to this dilemma is to raise their cash dividend by at least the perceived rate of inflation (creating a quasi “growth bond”), make acquisitions for cash (often overseas), and buy back stock.

Those who sold their shares back to the company received cash, which should have been reinvested into equities to maintain their stock/bond ratio. The size of buy-backs in 2019 appear to be smaller than those in 2018, making the chore of reinvesting more difficult. The enthusiasm for seemingly attractive stocks is less this year, resulting in cash building up in both institutional and individual investors portfolios. Because the cash build up was reinvested in short term paper while awaiting better (lower) prices, it increased the willingness to pay higher yields.

Less Equity Opportunities
The number of publicly traded stocks in the US has been falling for many years, resulting in about half the number of companies surviving. New enterprises are staying private longer, due to investments from private equity groups. Foreign companies have also been active buyers of both publicly traded and  private companies. Private equity managers have raised considerable amounts which need to be invested each year, further reducing opportunities and generally raising prices. This alone can make a market more vulnerable to a shock.

Investors may believe that they are well diversified, but they are probably not as diversified as they believe. Mutual funds are a good representation of how investors manage their money. With the smaller number of opportunities available, we are seeing the leading positions in the largest fund categories, like S&P 500 Funds, Global Funds and International Funds being dominated by the same large tech companies. Each of these funds has a few to over half its ten largest stock holdings represented in the twelve largest tech-oriented firms. If one includes the largest users or suppliers, the tech exposure probably represents the single largest driver of the funds’ performance.

Political Fears
The speeches and political commentary in numerous countries, including the US, is frightening some investors away from their long-term responsibilities. Many of these investors have seen  confiscatory taxes, capital controls (exporting capital) and limiting profitability in their lifetimes. The US looks more favorable to some than their home country, so cash is flowing into the US dollar. Some or most of this cash is going into short-term instruments, which is pushing up short rates.

Within the US, the presidential primary season has been a scene where each potential candidate seems to be trying to be more left oriented than the others. For those with capital and long-term responsibilities there does not appear to be a single large safe home for investment, leading to an increase in international investing. Traditionally, one invests outside of one’s home country for opportunities not found within it, but some of today’s international investors are seeking safety or at least a different set of circumstances or projected time frames. Thus, one can see a heavily US oriented portfolio being hedged with some Asian/Chinese positions. The hope being that the hedged elements do relatively badly, meaning that the US holdings on balance do well. This reminds me of a quote from John F. Kennedy in the latest Marathon Global Investment Review: “Change is the law of life. And those who look only to the past or present are sure to miss the future.”

How the global population feels towards “things” and people is one of the key change agents in the demand for products, services, and investments. An interesting article in The Wall Street Journal (WSJ) this week indicated that young people in China and I believe in Japan are taking on debt for products and services, mirroring the behavior of those in the US and other western countries. In both Chinese and Japanese societies saving was a paramount goal to provide for future healthcare and retirement. This generation seems to spend their pay entirely on purchases and the repayment of consumer debts. They are setting up permanent households later and having fewer children, leading to an expansion in the number of financial intermediaries, rather than providers of mortgages and long-term investments. These changes are modifying the slope and nature of the yield curve, favoring short-term borrowing funded by longer-term capital.

One of the areas of specific interest is the use and ownership of autos and related vehicles. With the building of mega cities that have reasonable public transportation supplemented by ride-sharing, there is a smaller need for private autos and the financing to support them. All of these changes shorten the time horizon of an increasing portion of the population, not only changing the structure of yield curve, but the political attitudes concerning what is important. Increasingly, societies are sacrificing the future for the present, ignoring JFK’s admonishment mentioned above. Bear in mind, he was the first young president of the US.

Interest Rate Inversion?
In my mind there is no doubt that we will have a recession during the next five years. In the post-mortem examination of the predictive elements, some may claim that notice was given when short rates were for some period higher than long rates. Because of the changing conditions for money I would note the inversion, but not place too much faith on in its predictive skills

Investment Conclusions
  1. Prune the portfolio of those holdings currently trading at a loss, whose prospects are not exciting.
  2. Reduce all levels of debt.
  3. Slowly start a recovery portfolio that is quite different than the present one.
  4. Consider some exposure to value investing, but separate value into mispriced stocks and bonds vs. deep value plays. The latter will be selling at discounts of 25% or more from current value, with control in weak or feeble hands.
  5. Look to the more distant future. One place to look is this week’s Bloomberg Businessweek entitled “The Elements”. The magazine suggests some unexpected winners and losers from the commercialization of the lesser known chemical elements, but patience will likely be required. 

Did you miss my past few blogs? Click one of the links below to read.

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A. Michael Lipper, CFA

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Sunday, August 25, 2019

An Awkward Moment with Frustration not Exhaustion - Weekly Blog # 591

Mike Lipper’s Monday Morning Musings

An Awkward Moment with Frustration not Exhaustion

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

Trying to develop a sound long-term investment strategy at any time is difficult, as most of the time we are clearly not at a top or bottom of a significant market move. We wander along an uncertain path to an eventual turning point, but each day, or in my case week, I must read the current sign posts to decide whether or not to change direction on the path I am traveling. Currently, there are three difficult choices to select from:
  1. Stay reasonably fully invested in the upward sloping secular trend, accepting that there will be periodic cyclical movements.
  2. As the opportunities and risks in today’s world are not the same as in the past. We should become increasingly defensive by building meaningful cash reserves.
  3. Prepare for global policy mistakes that causes devastation.
I put the chances of being correct for each of these choices at 65%, 30% and 5%, respectively. On an overall basis I would improve my odds by sub-dividing the portfolio into timespan segments and periodically re-weight the commitments to the segments based on both perceived future conditions and the changing needs of the beneficiaries.

These three working conclusions are based on the following inputs:

Secular Continuation with Bouts of Cyclicality
  • Most of the current volume is being generated by those that have a short-term time horizon. They are being whip-sawed by politically oriented news which is generating a lot of frustration. However, it is not generating the quantity of transactions representative of final exhaustion, or a complete retreat from participation.
  • Nevertheless, traders are making decisions based on liquidity e.g. compare the ratios of advances to declines on the NASDAQ 211/314 vs. NYSE 411/229. (In general stocks on the NYSE trade in greater volume than on the NASDAQ) 
  • Net flows into and out of ETFs shows short-term withdrawals this week. The two largest withdrawals totaled $4.6 Billion and the two largest net purchases totaled $1.2 Billion. The S&P 500 and MSCI Emerging Markets were sold and Consumer Staples and Gold were bought. 
  • Even after Friday’s drop of 3% for the NASDAQ it is till up +16.63%, whereas the DJIA is up only +9.87%. Both gains will probably be larger than the total earnings gains for 2019, suggesting the market is looking for a good 2020.
Game Changers
  • Lower interest rates and less binding loan covenants are likely to cause more bad loans.
  • Only 42% of weekly prices are rising. Could we have deflation in goods and inflation in services and imported goods?
  • Last week the interest rate offered to depositors went from 0.65% to 0.73%, suggesting that banks are increasing lending in face of slowing demand for products and services.
Global Mistakes
  • The battle for dominance is essentially driven by defensive needs, not land or market dominance.
  • The Chinese have been thinking in these terms for more than a thousand years. The earliest example of their well-developed thinking is in the writings of Sun Tzu entitled “The Art of War”. Jessica Hagy has produced a book that visualizes Sun Tzu’s thoughts. These should be understood by other world leaders and are shown below:
    • Hold out baits to entice the enemy
    • Feign disorder and crush them
    • If your enemy is secure at all points, be prepared for him. If he is in superior strength, evade him.
    • If your opponent is temperamental, seek to irritate him. Pretend to be weak, that he may grow arrogant.
    • If he is taking his ease, give him no rest. If his forces are united, separate them.
    • Attack him where he is unprepared, appear where you are not expected.
    • These military devices, leading to victory, must not be divulged beforehand.
    • The general who wins battles makes many calculations before a battle is fought.
    • The general who loses a battle make but few calculations before-hand.
The Asia Times has an article entitled “China now has edge in Indio-Pacific”. It is based on a think tank report from an Australian group named United States Studies Centre. The study raises the question “Could the era of US military primacy in the Pacific be over? Their view is that internal conditions within the US suggests that it will not fully fund the needs of its National Defense Strategy. At the same time China is building a capability which in a surprise attack would destroy or cripple some or all of the US’s Western Pacific main installations in Guam and Japan. (Interesting that the report did not name our forces on Iwo Jima and in the Indian Ocean.)

My Point of View
As a former electronics, aerospace, broadcasting and conglomerates analyst, I have seen the power of small electronic components change massive companies and markets. The current “trade war” was designed to protect the primacy of our semiconductor technology, which is critical to both US and Chinese defense efforts. To paraphrase Admiral Alfred Thayer Mahan’s statement of Who controls the Seas, controls the world. I believe the two Emperors of China and the US are acting as Who controls (leads) semiconductors and related technology controls the defense of their countries.

An Important Question
Considering how long value focused managers have suffered, can we build portfolios that are able to survive a similar period, regardless of our investment strategy? Any thoughts?

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Sunday, August 18, 2019

Short-Term Recognitions Plus Longer-Term Work - Weekly Blog # 590

Mike Lipper’s Monday Morning Musings

Short-Term Recognitions Plus Longer-Term Work

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

Short-Term Recognitions
We have reports of financial cycles since the beginning of recorded history and are always in some phase of a cycle. The keys to financial survival and future success are to recognize where we are in the present cycle, something which is almost always difficult to do emotionally. It is tough to label the current down draft. Is it a trading incident, a correction (normally about 10% from peak), the beginnings of a “bear market” (normally about 20% from peak), or a major crises that occurs once in a generation, with a decline of 50% or more? Only time will tell which of the alternatives describe our immediate future.

In the current US stock market most of the trading volume is from groups that are short-term oriented. With this orientation they tend to react to changes in sentiment rather than long-term trends. In the current market environment, I tend to focus on price changes for the NASDAQ Composite Index, which has risen the most of the three main stock market indices. The Composite includes a fair number of tech stocks and companies that provide services. Both of these have been growing their revenues faster than the industrial companies in the Dow Jones Industrial Average (DJIA) and the more broadly invested Standard & Poor’s 500 Index. (If it weren’t for the weak performance of the mid/small mixed financial services companies in the NASDAQ Composite, the lead would be even larger.)

Viewed in this light, the most recent weekly difference in the number of stock prices rising or falling may be instructive. The New York Stock Exchange (NYSE) had 373 gainers and 440 losers, whereas the NASDAQ had 203 gainers and 516 decliners. The NASDAQ is only off -5.21% from its peak, half-way toward being labeled a correction. Clearly one goes through each gradation until the ultimate bottom is reached. Whatever the appropriate level, some further fall is a reasonable expectation.

As I and others have stressed, the current market is led much more by sentiment than the investment fundamentals found in financial statements. Nevertheless, one should recognize that sentiment can impact prices for securities, currencies, and commodities. Each week The Wall Street Journal (WSJ) shows the weekly price movement of 72 items. Like many sentiment indicators, the rises and falls are normally bound in a 60/40 range. This week only 30% of the prices rose, with 70% declining. If attitudes toward prices remain outside of their normal range, it could be significant and could point to a larger decline than a mere correction.

One statistical series that may be misinterpreted is the constant sale of stocks by well-known value investors. These trimmings are being viewed as disenchantment with the holdings and while some disenchantment may be true, before reaching that conclusion it is necessary to review their record of inflows and outflows. When these previously successful investors are forced to make a partial liquidation they often choose among their most liquid positions, not necessarily their weakest. This has been the pattern for many quarters. If the downturn becomes more pronounced the time for trimming will likely end and favor totally selling out of selected names that may not have the same chance of price recovery. This typically happens near the end of market declines.

Time to Build Research Lists
In past market declines my fellow analyst friends would have lists of names and prices they wish to recommend to clients and/or purchase for themselves. All too often these lists are not executed due to the low-level of confidence in the new analytical work being done. It is with these thoughts in mind that I am now suggesting that this is the time to begin in-depth work on new names, not in portfolios or coverage patterns.

The first place I would look for candidates is the mutual fund investment objective averages. There are 19 fund averages that have risen less than 6% this year and 4 that have produced negative returns. These are:

Agricultural Commodities     -8.88%
India                        -5.58%
Natural Resources            -5.26%
Base Metals Commodities      -2.80%

Apart from the funds focused on India, the other three are classic supply/demand vehicles which are now suffering from insufficient demand for the current supply. We know from history that these conditions lead to future supply being curtailed by the withdrawal of some of the participants, although with both population and wealth growth there is little question that future demand will be higher than today’s level in the future.

India is a fascinating opportunity currently experiencing internal political issues. Nevertheless, it is the fastest growing major economy in the world. Faster than China and within twenty years it will have a bigger population too. Fourteen of the remaining investment objectives focus on international investing, many with an Asian mandate, highlighting two possible attractions. The first is summed up in a quote from the Chief investment Officer of Matthews Asia. “Growth that depends less on trade and more on continued savings, efficient investment, and institutional reform. All things to which Asia remains committed.” For a global investor, the largest risks is a decline in the value of the US dollar relative to other major currencies. (This may also reflect a relative decline in the standard of living for many US residents.)

The only domestic oriented investment objective with a low year-to-date average return of +4.25% is Small Company Value Funds. As with other value-oriented investment objectives, performance has lagged most other groups for the past several years. These funds must meet redemptions by liquidating and dealers might not be willing to take their discard into their limited inventory. The three commodity types mentioned above will rise when their markets are dealing with shortages.

There is another category that at some point may include some real bargains, internally driven turnarounds. Internally driven turnarounds most often result from new leadership and the restocking of operating management with new talent. Introducing new products and services with attractive pricing will also help. Unlike the swing from oversupply to shortage, internally driven turnarounds take time and may attract short sellers who are not patient.

Investment Conclusions
  1. Review your portfolio for those positions you want to own for the next bull market and dispose of the rest.
  2. Start the lonely job of researching new potential holdings which are likely to be winners in the next new market phases.

Questions of the Week:
  1. Are you prepared for a down market?
  2. Are you looking for the next Bull Market Winners?  

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Sunday, August 11, 2019

Sentiments Approaching Reversal Points - Weekly Blog # 589

Mike Lipper’s Monday Morning Musings

Sentiments Approaching Reversal Points

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

In the near future US stock market sentiment will approaching a reversal point.

Handicapping the US Stock Market
The art of picking winning bets at the racetrack is called handicapping. The betting goal is the same for long-term investors, to have more money at the end than when you started. Note, unlike baseball it is not the number of wins vs. loses. Both handicappers and investors recognize they will be wrong a percentage of the time, but in both cases success is measured by the number of dollars remaining at the end of the game, suggesting that in order to cover the losses gains will need to be larger. As the portion of the wins must be bigger than the average win, most successful investing involves a streak of contrarian thinking.  With that in mind I’ve laid out my view of the current level of the stock market.

As of August 9th, the three major stock market indices have declined modestly from their recent record levels. (S&P 500 -3.54%, DJIA -3.92% and NASDAQ -4.45%) None of these are even near a -10% correction, a -20% bear market, or a generational decline of -50%. Even including the worst week of the year, the three indices are up between +15.87% and +23.14% from the lows generated on January 3rd. However, the weekly survey of sample members of the American Association of Individual Investors (AAII) shows that only 22% are bullish for the next six months, with 48% being bearish. These percentages are historically extreme. A somewhat more nuanced view is expressed by bond and bond fund investors that also indicates caution. For the week ended Friday, yields on a Barron’s list of high-grade corporate bonds yields fell 11 basis points vs. only 4 bps for a similar list of intermediate credits. (Remember, a fall in yield means prices rose, indicating increasing demand.) During the trading week ended Thursday, General US Treasury Bond funds rose +2.25%, while the average High Yield fund declined -0.48%. It’s interesting that in a week where the Fed lowered interest rates by 25bps, the flight to safety pushed US Treasuries higher. 

Like Charlie Munger and Warren Buffett I am not a big fan of book value as a measure of operating success, although it is somewhat useful as a gross comparative measure. Comparing last week’s market to book value with those of a year ago, the DJIA declined very slightly, while the S&P 500 is the same as a year ago. Thus, the market is not grossly overpriced despite second quarter earnings being flat. According to analysts, the current quarter is expected to show a 1-2% decline that will be made up in the fourth quarter.

However, there is still reason to be concerned. On a year to date basis mutual funds have gained 2-3 times their average rate of gain for the last five years. Additionally, they are producing gains that are higher than their very long-term rates of return. Funds limited to the largest stocks, both within the US and abroad, have gained +14.47% year-to-date on average, compared to their five-year average return of +5.77%. Multi-cap Funds, a group of funds without a size limit which often has some large caps, were up +13.74% year-to-date and +5.32% for the past five years. Funds focused mostly on US holdings did somewhat better than those invested abroad due to having more tech holdings and the long-term rise in the dollar.

Short-Term Investment Thinking
Just as the betting results on the most favored racehorses is not great because they rarely produce enough betting winners to cover losses, I am betting against both the AAII crowd and the buyers of US Treasuries. I would also not be surprised if 2019 ends with high single-digit equity gains. In most of our managed accounts I would not disturb the highly selected funds in our portfolios.

Caution: Healthcare Could Look Like Financial Services in the Future
Over my professional investment life the Financial Services business has been quite good to me and my family. However,  the average rates of return have not been as good as they were in prior decades. Looking at the structure of these businesses today, while the numbers are larger the number of people and firms have shrunk. The number of publicly traded firms has been cut in half. The rates of return are also smaller than what they were years ago. Perhaps the single best measure of the decline is that fewer sons and daughters of successful professionals and successful investors want to enter these businesses. In sum, I believe the percentage returns are smaller than those of past decades for most investors. There is a very real risk that the same trend will govern the Healthcare Industry.

As with the Financial Services business, the Healthcare business is already highly regulated by the government and it is likely to become more so. In both cases the purpose of government regulation is to make care available, better, and cheaper for the public. I have twin fears that it won’t happen. The first is a story in Sunday’s New York Times about an individual who went to Mexico for a knee operation  paid for by a generous employer funded insurance plan. This is just another example of what is now called medical tourism, in this case to lower costs. Non-US citizens, both the very wealthy and the very poor, are entering the US for healthcare services they can’t get at home. For many years US residents have been traveling to other countries to get medical treatments not been approved here. These trips, along with the number of Canadians in our hospitals, demonstrate that patients will travel to get what they believe to be better or cheaper medical care. They may or may not get it.

What has likely caused the increase in medical tourism is the combination of increased regulation and the limiting of profit making of doctors, hospitals, insurance companies, pharmaceutical companies and all their suppliers and servicers. As an investor, as well as portfolio consultant to a hospital, I have looked at their financials. The good ones are reasonably profitable, but increasingly many are not and therefore  one needs to look beyond the dollars of profit. The first ratio to consider is profit relative to investment. Perhaps more important, is their perceived ability to pay dividends to their owners. For the most part these organizations feel compelled to reinvest their so-called profit into their activities. In many ways I do not consider retained earnings as current profits, because as an outside investor I can’t spend it.

As someone who has a large family dependent upon me to pay some or all their medical bills, including insurance, I would appreciate lower medical costs. It is important to understand that insurance is temporary risk shifting, favoring long periods of paying premiums directly or through the workspace. In the end my real desire is for others to have the lowest costs, but I want the best care for my family and the best often includes the new best drug or procedure. My fear is that as we restrict profitability in the healthcare system we won’t get the lifesaving or life betterment new drug or procedure quickly enough.

Just as we are well served in the financial services businesses by an appropriate level of profit, we need to ensure that the healthcare system can do its job of making our lives better.   

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A. Michael Lipper, CFA

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